A financial dealing in which a business sells its accounts receivable to a specialized finance company is termed debt factoring. A discount finance company, also known as the factor, buys the receivable and becomes responsible for collecting the outstanding amount. This transaction is also otherwise known as accounts receivable factoring and financing.
Businesses use this type of dealing in order to develop cash flow and cut down the cash cycle. This way, the business can get instant cash from the factor performing the process of collection. There are several advantages and disadvantages when a business enters into a debt factoring agreement.
Primarily, the benefit of debt factoring is that it gives a fast way of financing. The business, instead of waiting to have cash from the accounts receivable from clients, will immediately get cash from the factor. This system can be crucial if a business needs money to pursue finance growth. Alternatively, it can also be of help for businesses that are cautious of taking on debt or giving equity to increase capital.
A possible advantage is security from bad debt. However, this will only be utilized if the business has gone into a non-resource factoring agreement. With this kind of agreement, the danger of bad debt is assumed by the factor. Simply put, if the account of the client cannot be collected, it is the factor that absorbs this loss.
Another potential advantage is cost effectiveness. By selling the business’ accounts receivable, effectively, it is transferring the whole process of collecting accounts receivable. Even though the cost of these procedures is built effectively into the account where the receivables are sold, it can still be beneficial for a company that wants to save time or decrease the needs of employees for back office work.
There are also several disadvantages that a business must consider before entering into a debt factoring agreement. First is the cost. Under a factoring agreement, the accounts receivable that the factor buys are at a discount. A factoring agreement may suggest very costly capital, which is dependent on the amount of discounts. This rate should be evaluated and measured against the rate of other financial methods that is available to the business.
Second disadvantage is the introduction of an outside influence into the business pursuant to working with a factor. The factor, being responsible for collecting accounts receivable, may try to influence the business’ sales practice.
Another disadvantage is bad debt liability. This would apply if the business went into a resource factoring agreement. With this type of agreement, any amount which can’t be collected from the customer is the responsibility of the business. Although the rate of the discount at which the factor buys the account is lower, possible charges for accounts not collected must be considered.
Finally, there’s the relationship with the customers. Having a third party directly dealing with clients might make customer’s perceptions of the business negative. This is particularly true if the factor makes aggressive or unprofessional habits when collecting.
Debt factoring is characterized by a business agreement that is complex. Normally, it needs a long-term contract and the changes of some processes in sales. When considering if debt factoring is a good option for a business, its advantage and disadvantages must be evaluated carefully in order to make the right decision.
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